Utility Stocks: There’s No Need to Chase This Rally

The fuel for utilities' outperformance may prove short-lived

The Utilities SPDR (XLU) has generated a total return of 4.3% so far in 2014, trouncing the -1.4% showing for the SPDR S&P 500 ETF (SPY) and second only to healthcare among the 10 major sectors. Many of the largest utility stocks — such as Dominion Resources (D), NextEra Energy (NEE) and Exelon (EXC) — have generated even stronger returns, as shown in the table below.

This rebound is undoubtedly welcome relief to investors in utility stocks, who largely watched from the sidelines during the bull market of 2013. Unfortunately, the primary drivers of the recent outperformance aren’t fundamentals, but rather broader trends that might not be sustainable.

Falling Bond Yields a Major Plus for Utility Stocks

One of the key drivers of year-to-date returns for utility stocks has been the sharp drop in Treasury yields. After closing 2013 above the key 3% level, the yield on the 10-year note dropped below 2.6% early last week. Utility stocks, by virtue of their above-average yields, are highly sensitive to rate movements — when Treasury yields drop, the sector’s dividends automatically become more attractive on a relative basis.

Unfortunately, the decline in bond yields isn’t likely to be a longer-term phenomenon. While worries about Federal Reserve tapering and stronger economic data caused the concerns about a bond-market meltdown to get ahead of themselves in late 2013, which set the stage for the rally, it’s unlikely that bond prices will post more than modest gains this year. Already, the yield on the 10-year has begun to climb again, retracing about 40% of its peak-to-trough move in just the past seven sessions.

This hasn’t taken a toll on utilities just yet, but it’s reasonable to expect that a continued move in the 10-year toward 3% will soon dampen returns for utility stocks.

Rising Natural Gas Prices

Natural gas prices spiked during January, providing an additional tailwind to XLU and the utility sector as a whole. From Jan. 9-29, the United States Natural Gas Fund (UNG) rose a whopping 35.8%. This has been a positive factor on utility stocks’ performance, since it allows certain companies to charge higher prices in the spot power market. (At the same time, the rising price of natural gas has pressured other segments of the market, as outlined here and here.)

This has been a plus for utilities and XLU in the short term, but it’s necessary to keep in mind that the U.S. continues to have a massive supply of natural gas, and that winter will soon be over in the Northeast — meaning there will be a lower chance for demand spikes stemming from cold weather or storms.

As a result, the strength in natural gas could prove short-lived. If it does, another tailwind for utility stocks could soon fall by the wayside.

Demand for Defensives Is Back

It also hasn’t hurt that the broader equity market was under the gun for the first four weeks of the year.

While smaller stocks and higher-beta market segments have regained their footing in February, the first month of the year brought a revival in defensive sectors with lower exposure to the turmoil in the emerging markets. Volatility certainly could return at any time — especially with stocks having come so far, so quickly, in the past week — but betting against this bull market is a tricky proposition until proven otherwise.

Fundamentals, Valuations Don’t Make the Case

Utility stocks could lose one or more of these pillars of recent support and keep chugging along if the fundamental story were intact. For the overall sector, however, the profile of growth and valuation isn’t particularly compelling. According to FactSet, utilities are expected to deliver revenue growth of 2.2% in 2014, behind the 3.7% estimated for the S&P 500 and ninth out of ten sectors (only energy is worse). Bottom-line earnings are expected to rise just 3.1%, last among all sectors and well below the 9.4% of the S&P.

Worse, the estimates for utility stocks are falling faster than those of the broader market. Estimated revenue and earnings growth for utilities have fallen 15.4% and 20.5%, respectively, since December 31, versus 7.5% and 11.3% for the S&P 500.

Despite this, FactSet reports that utilities are trading at a premium multiple to forward earnings (15.1x) versus both the S&P (14.6x) and the sector’s own 10-year average (14.0x).

That’s a steep price to pay for below-average growth and prices that have been propelled by trends that may not last much longer.

Stock

Ticker

YTD Return

Duke Energy

DUK

2.7%

Dominion Resources

D

7.2%

NextEra Energy

NEE

7.7%

Southern Co.

SO

2.5%

Exelon

EXC

5.7%

American Electric Power

AEP

5.9%

Sempra Energy

SRE

3.0%

PPL Corp.

PPL

3.3%

PG&E Corp.

PCG

7.1%

Public Service Enterprise Group

PEG

7.4%

Bottom Line

Utility stocks still provide the largest dividend yield of any sector in the market, and in that sense they remain a compelling play for longer-term, income-oriented investors. For now, however, there’s no need to rush into this sector — the market will almost certainly provide patient investors with a more favorable entry point before long.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.